The growing, sale, and use (medicinally and recreationally) of cannabis remains illegal at the federal level in the US, however, growing, selling, and using cannabis is legal in several US states. In terms of the taxation of cannabis companies on the federal level, the Internal Revenue Code Section 280E states the following:
“No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
The interpretation of this section is that since cannabis is classified as a controlled substance on the federal level, cannabis companies pay federal income tax based on their gross profit rather than their net income. This can have a significant impact on value when utilizing an income approach.
In valuation, the income approach utilizes either historical or forecasted financials to determine the cash flows, or dividend paying capacity a company will generate that can be utilized by an owner or investor. A larger tax liability decreases available cash flows for owners and investors. In this article, we aim to provide an example of how the tax liabilities of cannabis companies impacts their value when utilizing an income approach.
Our example includes 2 companies with identical income statements. However, as you can see below, Company A is a cannabis company while Company B is a restaurant:
Now, let’s examine the tax liability of Company A, the cannabis company, assuming a 21% federal tax and a 7% state tax:
As shown above, Company A’s federal tax liability is based on its gross profit because it is a cannabis company. Company A’s total federal and state tax liability in this example would be $851,200. When offsetting Company A’s net income with the tax liability, it would be left with $148,800 ($1,000,000 – $851,200) in cash flows for owners and investors. Now, let’s compare this to Company B with the same tax rates. Company B is a restaurant; therefore, its federal tax liability is calculated using net income, rather than gross profit:
Company B’s tax liability would be $265,300. After offsetting net income with the tax liability, Company B would be left with $734,700 ($1,000,000 – $265,300) in cash flows available to owners and investors.
So, Company B will have $585,900 more cash flows available to owners or investors than Company A. If we assume the Companies have a capitalization multiple of 5, this will mean that Company B, the restaurant, would be valued almost 5 times more than Company A, the cannabis company. This equates to $2,929,500 more in value.
As displayed in this example, the tax liabilities of cannabis companies have a significant impact on their valuation under the income approach.
FAZ has conducted several valuation engagements related to cannabis companies. These engagements have ranged from consulting on creating defendable forecasts to valuations related to raising equity, selling shares and gifting shares.
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